Why are there more UK profit warnings?

This week’s Capital Agenda Blog comes from Alan Hudson, Head of UK Restructuring.

UK quoted companies issued 58 profit warnings in the second quarter of 2018 – almost a third more than the same quarter last year. The EY Profit Warning Stress Index hasn’t been higher since Q4 2016, in the wake of the EU Referendum vote.  To add to this, we can also report that the third quarter of 2018 has started in an even more troubling vein, with profit warnings running at about double the rate we recorded in Q3 2017.

Why are there more UK profit warnings? In this week’s blog we use the latest and archive profit warning data – available on the new EY Profit Warning Console – to tell the story.

It’s never just the weather

The start of 2018 was exceptionally cold, the middle exceptionally hot. Both sets of conditions have triggered profit warnings, but the cold more so, with 14% of warnings citing the cold snap in Q2 2018.

Put this together with Q1 GDP growth of just 0.2% and it’s obvious that the ‘Beast from the East’ did have an impact on UK economic activity. But, the stuttering pick up since the thaw suggests that the economy – and UK companies – have issues beyond the weather. The cold also hasn’t been as strong driver of warnings compared with other harsh winters. In Q1 2011, 32% of warnings cited adverse weather.

It’s not just the consumer…

Most of the 29% year on year increase in total profit warnings in Q2 2018 comes from the consumer side of the economy. Almost a quarter of FTSE General Retailers warned in the first half of 2018, with the sector issuing 20 warnings in H1 2018, doubling the figure set in H1 2017.  As EY Profit Warning Console shows, retail profit warnings haven’t been this high since 2011.

Retail PW by sub-sector

Why? Consumer fundamentals are clearly still weak.  Real disposable income is rising at well below the pre-crisis average. Households dipped heavily into their savings to maintain spending in 2016-17; but savings ratios are now at record lows. No doubt then that the drain on the consumer purse – plus higher operational costs – are a major force behind the recent rise in retail profit warnings and restructurings. But, the fact that many retailers are still doing well, despite all this, reminds us that structural issues are also a vital part of this complex equation.

Complex because it’s never just one thing. Competition isn’t just coming from online, but from consumers’ increasing preference for buying experience over more stuff.  Many high-street retailers are suffering from overcapacity; but rents are just one part of problem – which makes CVAs just one part of the solution. Fundamentally, retailers need to find their unique selling point and to build a deep relationship with consumers to create loyal customers.  The best retailers are managing to do this and to find a way to leverage data to build sales and optimise profits across all platforms.  We are well beyond the point now where ‘online’ and ‘store’ can be thought of as separate.

It is increasingly about uncertainty

Following the top five reasons for warning since 2007 by quarter is like following the story of the UK economy through the ups and downs of the credit crunch, weather, oil prices and sterling.  But, there is one trend that we really look out above all others each quarter – contract disruption. It’s the cause of so many profit warnings – and chains of multiple warnings  – that each time it moves higher we have to ask if this is coincidence or trend.

In Q2 2018 we reached a six-year high in contract-related warnings and it certainly feels like a trend, with growing uncertainty about the direction of the UK and global economy – not to mention trade and geopolitics – delaying business spending.

Profit warnings from industrial sectors have remained at remarkable lows in the last year or so, helped by a weak pound and rising global markets – but could reverse if uncertainty continues to upset the business cycle. The last peak in contract-related warnings came in 2012, in midst of the Eurozone crisis, when delays and destocking hit business service and industrial sectors especially hard as escalating risks delayed investment and purchasing decisions.

It is because more companies are warning

This sounds like a truism, but it’s not always that simple. Sometimes the number of profit warnings rises – at least in part – because the same companies are warning again and again. Stress is obviously increasing for those companies, but it’s not necessarily expanding for UK plc as a whole.

Which is why our new EY Profit Warning Stress Index takes the percentage of UK quoted companies warning in the year-to-date and places that figure on a relative scale, where zero corresponds with the lowest percentage of companies warning since 2007 and 100 is the highest. A higher percentage of companies warning signals more stress. In Q2 2018, 65% of companies issuing a profit warning hadn’t warned in the last year compared with 52% in Q1 2018.  Our index is at its joint highest level since Q4 2016.

PW STRESS INDEX1

More ‘new’ companies tend to warn when stress intensifies in a sector or if there is a shift in market dynamics – which goes back to the points on retail and uncertainty above. Essentially it’s feeling tougher out there for more companies.

..and it is starting to hurt

The important final point to make in this context is that a more precarious earnings outlook puts stakeholders on a different footing – something we can already see in stressed areas. The median share price fall on the day of profit warning hit 15.9% in Q2 2018 – a two-year high. It suggests that investors are increasingly concerned about structural issues and what comes next. Thin summer trading could amplify market volatility – especially if geopolitical and trade tensions escalate.

PW Share prices1

Thus the price of any profit warning could be high and run well beyond the loss of share price, if confidence in that company dips.  To build resilience in such an uncertain outlook, businesses need to be prepared for a number of scenarios, from greater trade barriers to supply chain disruption to a sudden rise in wage costs.

Stronger companies who are nimble and innovative will be best placed to avoid warnings and respond to whatever comes next.